Estimating Continuing Value of a Company

There are two parts to the estimated value of a company based on future cash flows:

1. a portion of the value based on the initial, explicit forecast period, and,
2. a portion of the value based on continuing performance beginning at the end of the explicit forecast period.

Estimated value of a company
= Estimated Operating Value of the initial, explicit forecast period + Continuing Value beginning at the end of the explicit forecast period.


The continuing value (CV) 

• often exceeds half of the total estimated operating value, and 
• when early years have negative cash flows, the continuing value can exceed the total estimated operating value.

Two formulas for estimating continuing value

There are two formulas for estimating continuing value:

• the discounted cash flow (DCF) formula, and
• the economic-profit formula.

Other methods for estimating continuing value exist.

The convergence formula is related to the preceding formulas, for example, and it assumes that excess profits will eventually be competed away.

Some methods do not depend on the time value of money.  Those methods include

• using multiples such as P/E, 
• estimates of liquidation value and 
• estimates of replacement costs.

Valuing by Parts provides greater insights into where and how the company is generating value

Many large companies have multiple business units, each competing in segments with different economic characteristics.

Even pure-play companies often have a wide variety of underlying geographical and category segments.

If the economics of a company's segments are different, you will generate more insights by valuing each segment and adding them up to estimate the value of the entire company.

Trying to value the entire company as a single enterprise will not provide much insight, and the final valuation will likely be noisier than valuing by parts.



Valuing by parts generate better valuation estimates and deeper insights

Consider a single case where a faster-growing segment has lower returns on capital than a slower-growing segment.

If both segments maintain their ROIC, the corporate ROIC would decline as the weights of the different segments change.

Valuing by parts generate better valuation estimates and deeper insights into where and how the company is generating value.

That is why it is standard practice in industry-leading companies and among sophisticated investors.



Steps for valuing a company by its parts

Four critical steps for valuing a company by its parts are:

1. understanding the mechanics of and insights from valuing a company by the sum of its parts,
2. building financial statements by business unit - based on incomplete information, if necessary,
3. estimating the weighted average cost of capital by business unit, and 
4. testing the value based on multiples of peers.

To value a company's individual business units, you need income statements, balance sheets, and cash flow statements.

Ideally, these financial statements should approximate what the business units would look like if they were stand-alone companies.

Creating financial statements for business units requires consideration of several issues, including

1. allocating corporate overhead costs,
2. dealing with inter-company transactions,
3. understanding financial subsidiaries, and 
4. navigating incomplete public information.

Inflation

Inflation makes analyzing performance and making comparisons difficult.

Inflation usually impedes the creation of value.

Inflation lowers the value of monetary assets and the firm can rarely pass along the full effects of inflation to customers.

Typically, ROIC does not increase enough to compensate the firm for inflation.

The increase in inflation from the 1960s to the 1970s was accompanied by a decline in P/E ratios.



Periods of High Inflation

During periods of high inflation, the problem becomes much worse.

During periods of high inflation, the following distortions can occur and need to be corrected:

1. overstated growth,
2. overestimated capital turnover,
3. overstated operating margins, and 
4. distorted credit ratios.

When making forecasts in periods of high inflation, adjustments can be make in either nominal or real terms.but consistent financial projections require elements of both nominal and real forecasts.

Five steps for making forecasts in periods of high inflation are:

1. forecast operating performance in real terms,
2. build financial statements in nominal terms,
3. build financial statements in real terms,
4. forecast free cash flow in real and nominal terms, and 
5. estimate discounted cash flow (DCF) value in real and nominal terms.

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

How good is the company in creating value for its shareholders? How much value can it create?

The chief measures for judging a company are

• its ability to create value for its shareholders and 
• the amount of total value it creates.

Corporations that create value in the long term tend to increase

• the welfare of shareholders and employees 
• as well as customer satisfaction.

 They tend to behave more responsibly as corporate entities.


Value Creation

Value creation occurs when a company GENERATES CASH FLOWS AT RATES OF RETURN THAT EXCEED THE COST OF CAPITAL.

Accomplishing this goal usually requires that the company have a COMPETITIVE ADVANTAGE.

Strengthening its competitive advantage also creates value in the long run.



Activities that do not create value

Activities such as leverage and accounting changes do not create value.

Frequently, managers shortsightedly emphasise earnings per share (EPS).

• A poll of managers found that most managers would reduce discretionary value-creating activities such as research and development (R&D) in order to meet short-term earnings targets.
• One method to meet earnings targets is to cut costs, which may have short-term benefits but can have long-run detrimental effects.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

The Stock Market is Smarter than We Think

The only 2 drivers of value creation are:

1. Return on Invested Capital (ROIC) 
2. Growth

Return on invested capital (ROIC) and growth are the only drivers of value creation.



Activities that do not drive value creation

Managers often spend time and resources attempting to:

• smooth earnings, 
• meet earnings targets,
• stay listed in a stock index,  
• become cross-listed,
• change the accounting rules, and 
• do stock splits.

The evidence shows that the stock market does not reward these efforts.  

Changes in accounting rules and stock splits do not have lasting effects.

ALL the above issues do not have an effect on stock returns unless they reflect a change in fundamental value.

Listing and delisting from an index and cross-listing

Listing and delisting from an index do not seem to have long-term effects for any given firm.

Although there can be a negative effect initially from delisting, the effect usually reverses in a few months.

Furthermore, cross-listing within developed markets does not have an effect; however firms in emerging markets may benefit from cross-listing in a developed market.



Accounting Changes

Investors apparently see through accounting changes.

If investors focused on earnings, for example, a move from FIFO to LIFO would lower the share price, but it generally does the opposite because of the increase in cash flows.

Another example, mere changes in goodwill do not affect share price; however, a change in goodwill that is associated with a real change in the firm produces a reaction from sophisticated investors.




Mispricing in the Market

Two possible sources of mispricings are:

1. the combinations of overreaction, underreaction, reversal and momentum, and
2. bubbles and bursts.

Unrealistic expectations of continued growth, which led to excessively high P/E ratios, caused the tech bubble in the late 1990s.

High earnings that were not sustainable caused the credit bubble a decade later.  In this case, it was not that the P/E ratios were too high, but that the earnings in the ratio eventually had to fall.

The basic source of value creation is competitive advantage. A High ROIC is the result of a Competitive Advantage.

A High ROIC is the result of a Competitive Advantage


The basic source of value creation is competitive advantage.

A high ROIC is the result of a competitive advantage from

• being able to charge a higher price or 
• being able to produce at a lower cost.

A strategy model for competitive advantage (Porter's framework)

A structure-conduct-performance framework provides a strategy model for competitive advantage.

One of the most widely used approaches in analyzing strategy is Porter's framework, which focuses on

• threat of entry,
• pressure from substitute products,
• bargaining power of buyers,
• bargaining power of suppliers, and,
• the degree of rivalry among existing competitors.

These forces differ widely by industry.



Five pricing advantages and Four cost advantages

Five pricing advantages and four cost advantages determine overall competitive advantage.

The five pricing advantages are:

• innovative products,
• quality,
• brand,
• customer lock-in, and,
• rational price discipline.

The four cost advantages are

• innovative business methods, 
• unique resources,
• economies of scale, and,
• scalable products/processes.

Pricing and cost advantages can erode through competition

In a competitive economy, the pricing and cost advantages can erode through competition.

The sustainability of the high ROIC from a competitive advantage depends on issues such as

• the length of the life cycle of the business and 
• the potential for renewing products.

Relative ROIC of a firm is fairly sustainable for periods of 10 years or more.

The evidence shows that the relative ROIC of a firm to the average of all other firms and to the firms in the industry remains fairly sustainable for periods of 10 years or more; however, there will be some reversion to the median and/or mean.




Additional Notes:


ROIC

=   NOPLAT / Invested Capital

= {(1- Tax Rate) * [Price per Unit - Cost per Unit]}/Invested Capital per Unit


NOPLAT = Net Operating Profit less Adjusted Tax

This formula explains how a higher ROIC is the result of a competitive advantage from being able to charge a higher price or being able to produce at a lower cost.

Growth

The two sources of organic growth are:

1. increase in the size of the market, and 
2. increasing market share.

The drivers of growth of business, in order of size, from largest to smallest, are:

1. Market growth
2. Mergers and acquisitions
3. Market share growth

Incremental Innovation and Growth

Incremental innovation will rarely create lasting value, because competitors can easily retaliate.

Competitors can either

• lower the prices on their existing products, or,
• if the innovator raises the price of the improved product, keep their prices the same.

Also, the rivals can also come up with their own incremental innovations, which is easier than coming up with a new product or service.



Product Development and Growth

With respect to product development, growth is difficult to maintain because for each product that is maturing and reaching its peak in revenue, the company must develop a new product that will grow faster to replace it.

This is called the portfolio treadmill effect.




Why have publicly traded firms grown at a higher rate than GDP?

The two reasons for this are:

1. Publicly traded firms can grow faster because of their ease in raising capital, so their growth can be higher than the overall economy at the expense of nonpublic firms.
2. Public firms have experienced higher growth from expanding sales to overseas markets, and expanding markets and bringing in new consumers are the most effective means of growing and creating value.

Better Investor Communications

Managers should communicate with investors to help align the value of the stock with the intrinsic value of the company.

Negative consequences of an underpriced stocks

If the stock is underpriced, a few of the negative consequence are that:

• employees may be demoralized, 
• the stock is less useful in stock acquisitions, and 
• the firm may become a takeover target.

Negative consequences of an overpriced stocks

If the stock is overpriced, the price will eventually fall, which will lead to:

• a fall in employee morale and 
• increased tension between the board of directors and the managers.
• Also, once the stock is overpriced, managers may engage in value-destroying activities in an attempt to prop up the stock price.

How can companies improve investor communications?

Three ways many companies can improve investor communications are to:

1. monitor the gap between price and intrinsic value,
2. understand the investor base, and 
3. tailor communications to the investors who matter most.

In general, the managers should try to communicate with sophisticated intrinsic investors because the activities of these investors have the most impact on the price of the stock.

Managers should be honest and not use gimmicks such as changing the metrics reported each period to give the most favourable numbers.

How useful is earnings guidance?

Earnings guidance does not provide any discernible benefits.

Mergers and Acquisitions (2)

Acquisitions rarely create value unless they do one or more of the following:

1. improve performance of the target company,
2. remove excess capacity,
3. create market access for the acquirer's or target's products,
4. acquire skills or technologies at a lower cost and/or more quickly than could be done without the acquisition,
5. exploit a business's industry-specific scalability, and
6. pick winners early.

Most of the value of an acquisition goes to the target's shareholders unless one or more of the following hold for the acquirer:

1. it had strong performance before the acquisition,
2. it can pay a low premium,
3. it had fewer competitors in the bidding process, and 
4. the acquired assets were from a private firm or a subsidiary of a large company.

Value Created for Acquirer

The value created for the acquirer is:

Value Created for Acquirer
= (Stand-Alone Value of Target + Value of Performance Improvements) - (Market Value of Target + Acquisition Premium).

Mergers and Acquisitions (1)

Empirical research has shown that acquisitions have come in waves and generally rose when

• stock prices were high, 
• interest rates were low and 
• one or more large deals had already taken place.

Of the mergers and acquisitions:

• 1/3rd of the deals created value for the acquirer,
• 1/3rd destroyed value, and 
• 1/3rd had unclear results.

Cost analysis

Cost savings can create value, but estimating those savings requires a framework.

As an example for a generic drug firm, the analyst might allocate the savings into six categories:

• R&D,
• procurement,
• manufacturing,
• sales and marketing,
• distribution, and 
• administration.

Assumed cost savings should be estimated and categorized in detail to avoid double counting.

It is recommended that those directly involved in the cost-savings process be involved in the estimations of cost savings.



Revenue analysis

Revenue analysis has both explicit and implicit considerations.

Revenue improvements generally have four sources:

• increasing sales to a higher peak level,
• reaching a peak level faster,
• extending the life of products, and 
• adding new products.

Revenue could increase from higher prices, but antitrust regulation can prevent higher prices unless the quality of the products increases.




Stock offer or cash offer

Generally, an acquiring firm's stockholders benefit more if the firm uses stock instead of cash for the acquisition.

Although the stock offering can lead to dilution, it lowers the risk to the acquirer and allocates more risk to the target firm's shareholders.

Research has shown that stock prices react to creation of intrinsic value in an acquisition and that dilution and other accounting issues do not matter.

Performance management systems.

These systems align decisions with short- and long-term objectives and the overall strategy.

Such systems typically include:

• long-term strategic plans,
• short-term budgets,
• capital budgeting systems,
• performance reporting and reviews, and 
• compensation frameworks.

The rigor and honesty of implementing the system is at least as important as the system itself.

Implementing the system includes

• choosing the metrics, 
• composing the scorecard, and 
• setting the meeting calendars.

1.  Choosing the right metrics

Choosing the right metrics means identifying the value drivers.

Typically the ultimate drivers are

• long-term growth,
• ROIC, and
• the cost of capital.

Short- , medium-, and long-term value drivers determine growth, ROIC and the cost of capital.


Short-term value drivers

Short-term value drivers are usually the easiest to quantify, and examples include

• sales productivity,
• operating cost productivity, and 
• capital productivity.

Medium-term value drivers

Medium-term value drivers consist of

• measures of commercial health, 
• cost structure health, and 
• asset health.

Long-term value drivers

Long-term value drivers address strategic issues such as

• ways to exploit new growth areas and 
• the existence of potential market threats.

Understanding the value drivers allows the managers to have a common language for their goals and to make better choices of trade-offs between critical and less critical drivers.


2.  Composing the Scorecard


Balanced scorecard approach

This was introduced by Robert S. Kaplan and David P. Norton in "The Balanced Scorecard:  Measures That Drive Performance" (Harvard Business Review, February 1992).

This approach can reflect many aspects of the firm and its goals.

The choice of critical drivers should be tailored to the firm's businesses.



A tree based on profit-and-loss structure approach

This is often the most natural and easiest to complete.

The targets need to be challenging and realistic, however, and should not consist of only a single point.

One recommendation is the use of base and stretch targets, where achieving the latter reaps a reward for the manager and not a penalty.



3.  Organizational Health

In addition to determining the drivers and targets, managers should assess organizational health, which is determined by

• the people, 
• skills and 
• culture of the company.

Managers should help set the targets to better understand these issues.

Fact-based reviews with appropriate rewards should depend on:

• stock performance where macroeconomic and industry trends have been removed,
• long-term assessments that might mean deferring rewards, and 
• measures of performance against both quantitative and qualitative drivers.

The firm should harness the power of nonfinancial incentives, such as creating a culture that attracts and motivates quality employees.

What future return can you get for investing into Public Bank Berhad?

We should keep our investing very simple and readily understandable.

Public Bank Berhad is a strong bank in Malaysia. Banking sector is highly regulated. Public Bank Berhad has done very well for decades building its banking business in Malaysia and increasingly in our neighbouring emerging countries. The challenge going forward is how well it adopts to new financial environment, in particular, that of fintech.

Its revenues, profits before tax and earnings per share have grown consistently over the last decade. It is this consistency and growth that confer to this company its high investment qualities.

It has also been distributing dividends regularly. Dividends have grown over the years (dividend growth investing). In the previous decade, it paid a higher dividend paid out relative to its earnings. It is presently paying out about 44% of earnings as dividends. It retained about 56% of its earnings in recent years. Its return on equity for the last 5 years averaged around 16.7%, which is remarkable. As an investor, I am happy that Public Bank Berhad is able to generate this high level of return on its equity. Its dividend payout ratio has declined in recent years due to its need to retain and build up its equity base in keeping with new Basel capital adequacy ratio guidelines.

It is a very well managed bank. It has been growing its net interest income and non-interest income satisfactorily without taking undue or too high risk.

At its present price of $19.98 per share, how attractive is Public Bank Berhad as an investment for the long term? Long term is taken to mean a period of at least 5 or 10 years.

Here are some facts and my opinion on Public Bank Berhad below.

1. At 19.98, it is trading at a PE ratio of 14.90.

2. It is trading at its fair price (neither undervalued or overvalued).

3. Its reward:risk ratio (based on my own method) is 6.84:1 (the probability risk of losing money is low and the reward: risk ratio is in your favour).

4. At the present price, assuming its future consistent growth in earnings per share of 6% per year (very conservative), this company can be expected to give about 13.07% simple average annual total return (= Annual capital appreciation of 9.62% and Average annual dividend yield of 3.45%) or 10% compound annual total return over the next 5 years.

5. At the present price of $19.98 and last FY dividend of 58 sen, its present Dividend Yield is 2.89%. Assuming its earnings and dividends grow consistently at 6% annually the next 5 years, we can expect a back of the envelop calculation return of approximately 2.89% + 6% = 9% annually (simple average). At such a conservative assumption in our calculation, this company may well surprise on the upside, making its investors happier.

I sought a higher return of 15% per year. This illustration shows that to get a return of 8% to 10% in the stock market or a stock, is actually quite achievable. To get a higher return, is more challenging than most realise.


Good luck in your investing.



Additional Notes:

Intrinsic value or Price
= Dividend / (required rate of return - growth)
= D / (r-g)

P = D / (r-g)
r-g = D / P
r = (D/P) + g
r = (Dividend Yield) + g

If you invest into a company that grows dividends at a constant rate of g, your expected return can be easily worked out as:

r = (Dividend Yield) + g

The present DY of Public Bank Berhad is 2.89%.

Our assumption is its dividend will grow at 6% per year.

Therefore, we can hope for a return of 2.89% + 6% = 8.89% or 9% per year.

Public Bank Berhad's last financial year dividend of 58 sen can support a share price of $16.25.


[Disclaimer:  Please do your own diligent analysis before investing.  Your investing should be based on your own analysis and informed decision.  This is not a recommendation.  You invest at your own risk.]

Howard Marks: "The Most Important Thing - Origins and Inspirations"

Talk at Google



https://www.oaktreecapital.com/insights/howard-marks-memos

OCBC Q1 profit rises 14pc, driven by wealth management business

Tue, 9 May 2017 SINGAPORE: Singapore's Oversea-Chinese Banking Corp Ltd reported a nearly 14 per cent rise in quarterly profit, largely led by sustained growth in its wealth management business and robust results from insurance operations. The city-state's second-biggest lender said net profit came in at S$973 million (US$692 million) in the three months ended March 31 versus S$856 million a year ago. Net interest margin however contracted 13 basis points to 1.62 per cent. "We achieved broad-based loan growth, grew our private banking assets under management (AUM), and reported significantly higher fee income," chief executive officer Samuel Tsien said in a statement on Tuesday. The bank said the overall quality of its loan portfolio remained stable and although the stress in the oil & gas support services sector continued, sufficient provisions had been made. OCBC is the last Singapore bank to report results after DBS beat market estimates and United Overseas Bank posted an increase in quarterly profit. -- REUTERS

JJPTR, lasted barely 2 years before it collapsed in April 2017

Johnson Lee, 29 year old, started this "investment product" promising return of 20% per month on the money invested.

How did he invest these money to get such high returns?

Did the investors ask this simple question before parting with their hard earned money?

I believe many wondered how he was able to promise such high returns and probably knew that this was too good to be true.

However, they threw caution to the wind when their colleagues or friends who entered the scheme earlier started receiving their monthly 20% return of their investment.

The early birds benefited for the period and this attracted the new comers.

Some put a small amount of money initially as a gamble on the scheme, but soon lost control of their emotions, adding more money into the scheme, when they started to receive their 20% returns monthly.

Now that the whole scheme is broken, those who are in it should be prepared to lose a large percentage, if not all, of their invested money.

Sadly, Johnson Lee has announced another scheme, somewhat similar, but now promising 35% return on capital monthly.

Of course, the question that has to be asked is:  If Johnson Lee cannot sustain the previous scheme that promised 20% per month return from investment, how can he hope to sustain this new scheme that promises an even higher return per month?

Those who usually make such proposals are either very confident in their abilities, or are very dishonest, or suffer from delusions on a grandiose scale.

Similar schemes had surfaced and collapsed in the past, leaving many of those who invested in them impoverished.

Why are such schemes so common in Malaysia?

Accounting for Project Development Costs

ACCOUNTING FOR REAL ESTATECOST ACCOUNTING

ACCOUNTING FOR PROJECT DEVELOPMENT COSTS

---

     

                                                                      The costs associated with the development of a project are accounted in different ways, depending on the nature of the costs and the stage of the project. Some costs are

• expensed as period costs, 
• some are capitalized when incurred as costs of the project, while 
• others are recorded as prepaid expenses and expensed in the period in which the related revenues are recognized.

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There are three main stages of a development project, and accounting at these stages can be different. The three main stages are: (1) Pre-development stage; (2) Development stage; and (3) Post-development stage.

Accounting for development projects requires knowledge of regulatory requirements and pronouncements from various accounting bodies. This post aims to make these requirements and pronouncements simpler and easier to understand and also to offer a practical application of the pronouncements. Also, it discusses the accounting for costs related to acquiring, developing, constructing, selling, and leasing real estate projects.

Accounting In The Pre-Development Stage

The predevelopment stage can be described as the period prior to the start of the construction of the project. Let us start the discussion of accounting for predevelopment from the very beginning, at the inception of the entity that will own the project. Normally the sponsor(s) of a project form a legal entity that directly owns the project. The start-up costs related to the formation of this legal entity should be expensed as incurred. These start-up costs include the related filing fees, legal fees, and other regulatory fees.

In the past, the accounting for start-up costs was handled differently by different companies in different industries. Some companies expensed their start-up costs while others capitalized them and amortized them over time. As a result of these inconsistencies, in April 1998 the AICPA Statement of Position No. 98-5, Reporting on the Costs of Start-up Activities, was issued. It requires that start-up costs and organization costs are period costs and should be expensed instead of capitalized.

Some examples of predevelopment costs related to a project itself include: Acquisition options, Market studies, Traffic studies, Zoning changes, Survey costs, Costs of securing debt financing, Costs of securing equity partners, and Marketing costs.

It is important to pay particular attention to these costs to ensure that they are recorded correctly, as some are required to be expensed while others are required to be capitalized. GAAP requires that all costs associated with a project that are incurred prior to the acquisition of a property or before the entity obtains an option to acquire the property should be capitalized if all of these three conditions are met:

• The costs are directly identifiable with the specific property.
• The costs would be capitalized if the property were already acquired.
• Acquisition of the property or of an option to acquire the property is probable.

As mentioned, these three criteria have to be met for costs incurred prior to the acquisition of the property or option to acquire the property to be capitalized. The criteria require that such costs should be directly related to the property. Therefore, costs incurred at this stage should be examined carefully to make sure that they relate specifically to the property and are not general costs incurred by the entity.

Some examples of directly related types of costs include project-related travel costs and consulting fees specifically related to the property prior to acquisition or obtaining option to acquire the property.

Another criterion mentioned is whether the cost would be capitalized had the property already been acquired. Therefore, the entity needs to assess whether the nature of the cost is such that it would be capitalized.

An example is where the buyer, with the agreement of seller, decides to perform certain environmental tests prior to the decision on whether to purchase the property. Such costs clearly are costs a buyer would incur if the buyer already owned the property.

The last of the three criteria says that acquisition is probable. Here the test is both the ability of the buyer to close the deal and also that the subject property is available for sale. Therefore, even if the potential buyer is able and willing to purchase a particular property, if the property is not available for sale, this criterion is not met. Therefore, the costs should not be capitalized.

If the costs meet all three conditions mentioned, those costs are required to be capitalized; while all other costs should be expensed as incurred. It is also important to note that the cost to acquire an option to purchase a property must be capitalized. In most cases, even though all the criteria are met, there is no guarantee that the property would be acquired.

Therefore, at any time when it becomes probable that the property would not be acquired, the prior capitalized costs would have to be expensed.

Other predevelopment costs that meet the criteria for capitalization include costs incurred to change the zoning of the site and costs incurred to obtain financing, such as loan fees, points, and origination fees. In most cases, the developer starts marketing the project prior to the start or completion of construction. Therefore, marketing and other selling costs would be incurred at different stages of development.

Accounting In The Development Stage

The development stage is the period with the most activities and costs among the three stages. It is also the longest period in the project development process. The accounting during this period is very important, as both a management and a cost control tool. Adequate care should be taken to ensure that costs are recorded in the correct cost category.

Examples of costs incurred during this stage are: Site costs, Architectural and engineering, Financing, Construction, Taxes and insurance, General and administrative, Marketing, Permits and licenses, and Contingencies.

Normally in a construction project, a comprehensive budget is prepared with amounts for each of the cost categories just listed. The project’s construction, management, accounting, and finance teams meet periodically to review the budget with the actual costs incurred to ensure that costs incurred are recorded in the correct cost category or trade and also that the budget and amount left to complete the project are still reasonable.

As in other stages of the development process, some costs incurred during the development stage are capitalized while some are expensed based on the GAAP rules. According to Statement of Financial Accounting Standards No. 67, paragraph 7:

‘‘Project costs clearly associated with the acquisition, development, and construction of a real estate project shall be capitalized as a cost of that project.’’

The implication here is that for a cost to be capitalized as a project cost, there has to be a clear indication that it is directly related to a project.

Many costs incurred at this stage are mostly capitalized, such as site acquisition costs, architectural, engineering, and construction. However, certain other costs incurred during this stage that are not directly associated with the project should be expensed; these costs include general and administrative and marketing costs.

The invoices and other supporting documents related to these costs should be properly reviewed to determine the nature of the costs and to decide whether they should be capitalized or expensed.

In some instances, costs might be related to more than one project. For example, say a developer is developing an office complex with multiple individual buildings, and bills for certain costs, such as surveys or architects for the whole complex, are billed together. Such costs are still capitalized, but they would have to be allocated among the individual buildings. The developer should use any reasonable method to allocate the costs among the individual projects.

Amortization of Costs

Financing costs such as origination fees, points, and guaranty fees should be capitalized as prepaid assets and amortized to periodic project costs.

Example:

Assume an entity obtained a construction loan of $100 million for an office development project due at the completion of the project in 3 years with an interest rate of 8 percent. At closing, the borrower paid 1 percent origination fee, 1 percent point, .05 percent debt guaranty fee, and other loan closing costs of $525,000.

Therefore, the total costs incurred by the borrower at closing, which are usually disbursed from the loan principal, would be:

Origination fee (1%)          = $1,000,000
Point (1%)                          = $1,000,000
Guaranty fee (.05%)           = $   500,000
Other loan closing costs   = $   525,000
Total loan closing costs   = $3,025,000

At the day of closing, the entity would record this accounting journal entry:

[Debit]. Cash = $96,975,000
[Debit]. Prepaid assets = $3,025,000
[Credit]. Loans payable = $100,000,000

Note, however, that in most cases the borrower would not take the cash up front at closing but will draw on the amount periodically (usually once a month) as bills are received from contractors and vendors through a process called the submission of draw. On the amortization of the $3,025,000 total loan closing costs, each month the company reduces the prepaid asset by $84,028 ($3,025,000/36 months).

Therefore, each month, the journal entry to record this amount as project cost would be:

[Debit]. Loan financing cost = $84,028
[Credit]. Prepaid assets—loan cost = $84,028

This entry will be recorded each month over the 36-month loan term. If for any reason the loan term is extended, the monthly amortization will have to be adjusted.

Example:

Assume that six months prior to the loan expiration, the company realized that the project would not be timely completed due to a construction workers’ union strike. Management assessment indicates that the project will take an additional six months from the prior expected completion date. The borrower therefore approaches the lender, which agrees to extend the loan for the additional six months. The unamortized prepaid balance would now be amortized over the remaining loan term of one year, which is determined as the six months left on the original agreement plus the additional six-month extension.

The new monthly amortization would be determined as:

Unamortized balance prior to loan-
extension ($84,028 x 6)                     = $504,167
New amortization period                   = 12 months
Monthly amortization-
($504,167/12 months)                       =  $42,014

Therefore, after the extension, the monthly journal entry to record the cost amortization would be:

[Debit]. Loan financing cost = $42,014
[Credit]. Prepaid asset—loan cost = $42,014

Real Estate and Income Taxes

During construction, the entity may be required to pay taxes to the government. The most common taxes are the real estate taxes and income taxes. These two taxes are treated very differently in a construction project. For GAAP financial reporting purposes, costs incurred for real estate taxes from the inception of the project through the time at which the property is ready for its intended use should be capitalized as project costs. Real estate taxes after this period should be expensed.

The second type of taxes mentioned was income taxes. During the development stage, companies can still earn income through interest income on funds deposited at a bank or through parking revenues. Therefore, an entity might owe the government income taxes related to this income. These income taxes are expenses of the period and should be expensed.

Often some companies net their interest expense against interest income on their project budget; however, financial reporting under GAAP does not allow the netting of these two costs in financial statements.

As mentioned earlier, interest expense incurred through the time at which the property is ready for its intended use should be capitalized; interest income should be reported separately on the income statement when earned. The only exception in which interest income can be netted against interest expense is when the interest expense is from tax-exempt borrowings.

Another common error in financial reporting by some entities is the accounting for audit fees paid to the entity’s auditors for the audit of its financial statements. Audit fees are expenses of the period and not directly related to the project. Therefore, they should be expensed as incurred. In general, all expenses should be thoroughly reviewed to determine whether they should be expensed or capitalized.

Accounting In The Post-Development Stage

The post-development stage is the period when the project is substantially complete and is ready for its intended use. For example, if this is a condo project, the buyers can now move in; if it is a rental property, the lessees, if any, can now take possession of the spaces.

Most expenses incurred during this stage, such as salaries and wages, cleaning, security, utilities, water, and real estate taxes, are expensed as incurred. In addition, certain capital improvements performed after the completion of the project normally are capitalized and depreciated over the project’s useful life. Also, certain costs incurred in leasing the space (if a rental property), such as brokers’ fees and attorney’s fees, are also capitalized and amortized over the related lease term.

Reference:

http://accounting-financial-tax.com/2011/01/accounting-for-project-development-costs/

http://www.ey.com/Publication/vwLUAssets/FinancialReportingDevelopments_BB1883_RealEstateCosts_Dec2009/$FILE/FinancialReportingDevelopments_BB1883_RealEstateCosts_Dec2009.pdf

Market Fluctuations as a Guide to Investment Decisions (2) - Timing or Pricing

Stock Brokers and the Investment Services

As a matter of business practice (or perhaps of thorough-going conviction), the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts.

The investor can scarcely take seriously the innumerable predictions which appear almost daily and are his for the asking.

In many cases, he pays attention to them and even acts upon them.  Why?

Because he has been persuaded that it is important for him to form some opinion of the future course of the stock market and because he feels that the brokerage or service forecast is at least more dependable than his own.

This attitude will transform the typical investor into a market trader and will bring the typical investor nothing but regrets.



Timing in a Bull Market

During a sustained bull movement, when it is easy to make money by simply swimming with the speculative tide, he will gradually lose interest in the quality and the value of the securities he is buying and become more and more engrossed in the fascinating game of beating the market.

He begins by studying market movements as a "commonsense investment precaution" or a "desirable supplement to his study of security value"; he ends as a stock-market speculator, indistinguishable from all the rest.


Market Forecasting (or Timing)

A great deal of brain power goes into this field.

Undoubtedly some people can make money by being good stock-market analysts.

But it is absurd to think that the general public can ever make money out of market forecasts.

There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he is himself a part.


Timing and the Speculator

Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry.

The idea of waiting a year before his stock moves up is repugnant to him.



Timing and the Investor

But a waiting period of such, is of no consequence to the investor.  

• What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy?
• He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income.

Timing is of little value to the investor unless it coincides with pricing, that is, unless it enables him to repurchase his shares at substantially under his previous selling price.

Market Fluctuations as a Guide to Investment Decisions (1) - Timing or Pricing

Common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices.

Should the intelligent investor be interested in the possibilities of profiting from these pendulum swings?

There are two possible ways he may try to do this:

• the way of timing and 
• the way of pricing.

Timing

By timing, the investor try to anticipate the action of the stock market - to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward.


Pricing

By pricing, the investor endeavours

• to buy stocks when they are quoted below the fair value and 
• to sell them when they rise above such value.

A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks.

This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels.


Pricing or Timing?

The intelligent investor can derive satisfactory results from pricing of either type.

If he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator's financial results.

A sound mental approach towards stock fluctuations (5): Market Declines and Unsuccessful Stock Investments

Market declines and unsuccessful stock investments

In the case of market declines and unsuccessful stock investments, there is a vital difference here between temporary and permanent influences.

The price decline is of no real importance:

• unless it is either very substantial - say, more than a third from cost - or 
• unless it reflects a known deterioration of consequence in the company's position.

In a well-defined bear market, many sound common stocks sell TEMPORARILY at extraordinarily low prices. 

It is possible that the investor may then have a paper loss of fully 50% on some of his holdings, without any convincing indication that the underlying values have been permanently affected.



The Price can be Extraordinary in a Recession or Bear Market

In the business recession and bear market in the past, there were times, an outstanding business was considered in the stock market to be worth less than its current assets alone - which means less as a going concern than if it were liquidated.  That price was extraordinary.

Why?  The reasons maybe many.  

• The reasons were justified in some.   
• Yet, in some, the reasons were exaggerated and eventually groundless fear; 
• while others were typical of temporary influences.

An example:  

An investor bought ABC in 1987 at say, 12 times its five-year average earnings or about 80.  The share price declined to 36 soon after. 

What was the implication of the share price to him?  

• We cannot assert that the decline to 36 was of no importance to the investor.  
• The investor would have been well advised to scrutinise the picture with some care, to see whether he had made any miscalculations.  

But if the results of his study were reassuring - as they should have been - he was 

• entitled to disregard the market decline as a temporary vagary of finance, and,
• unless he had the funds and the courage to take advantage of it by buying more on the bargain basis offered.

A sound mental approach towards stock fluctuations (4): Advancing, Bull or Rising Market

Advancing or Rising Market

The investor is neither a smart investor nor a richer one when he buys in an advancing market and the market continues to rise.

That is true, even when the investor cashes in a good profit, unless either:

• (a) he is definitely through with buying stocks - an unlikely story - or 
• (b) he is determined to reinvest only at considerably lower levels.

In a continuous program no market profit is fully realised until the later reinvestment has actually taken place, and the true measure of the trading profit is the difference between the previous selling level and the new buying level.

A sound mental approach towards stock fluctuations (3): Market Price Fluctuations

Market Price Fluctuations

When the general market declines or advances substantially, nearly all investors will have somewhat similar changes in their portfolio values.

The investor should not pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels.

A sound mental approach towards stock fluctuations (2) Measuring Investment Results

Price Changes as Measuring Investment Results

The success of your investment program in common stocks must depend in great part on what happens ultimately to their prices.

• How far must you commit yourself to concern with the market's price fluctuation or conduct?
• By what market tests should you consider that you have been successful or not?

Yet, focusing on short-term or minor fluctuations will make you indistinguishable from the stock trader.

The experienced investors lean toward using a combination of dividend return and market-price change over a suitable period of time as the measure of investment success.  

• These calculations are made preferably between dates, several years apart, on which the general market level has not changed appreciably.
• The inclusion of the dividend income make this method a highly satisfactory one for testing investment results.
• It may be employed: 

1. (1) to measure the overall performance of an investor's portfolio, or 
2. (2) to compare one investment fund with another, or 
3. (3) to assess the merits of alternative principles of investment - for example, buying "growth stocks" versus buying undervalued securities.

Market Price Fluctuations

When the general market declines or advances substantially, nearly all investors will have somewhat similar changes in their portfolio values.

The investor should not pay serious attention to such price developments unless they fit into a previously established program of buying at low levels and selling at high levels.

A sound mental approach towards stock fluctuations (1)

Intelligent investment is more a matter of mental approach than it is of technique.

A sound mental approach towards stock fluctuations is the touchstone of all successful investment under present-day conditions.

Your portfolio should consist of:

(a)  Savings Bonds, which have no price fluctuations, and,

(b)  Common Stocks, which are likely to fluctuate widely in their market price.

Such changes in quoted prices may be significant to the investor in two possible directions:

(A)  As a measure of the success of your investment program.

(B)  As a guide to the selection of your securities and the timing of your transactions.